1. Harcourt Brace & Company Chapter 10 Externalities (Lecture by D. Boldt on 10/18/01 in Econ 2105-06

2. Harcourt Brace & Company Externality Principle #7 (Ch. 1) Governments Can Sometimes Improve Market Outcomes Government involvement may be needed in case of a Market Failure. One example of a market failure is a side effect of economic activity known as an Externality.

3. Harcourt Brace & Company Externality - Defined The uncompensated effects that the production or consumption of goods have on third parties. The impact of one person’s actions on the well-being of a bystander!

4. Harcourt Brace & Company External Benefits - Positive Externalities The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods. The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.

5. Harcourt Brace & Company External Costs - Negative Externalities The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods. The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.

6. Harcourt Brace & Company Negative Externality Air Pollution from a Power Plant Cigarette smoking Positive Externality Immunizations Outside Home Improvements Examples of Negative and Positive Externalities

7. Harcourt Brace & Company Externalities and Market Inefficiency - Negative Externalities Negative externalities lead markets to produce a larger quantity than is socially desirable. The Social Costs of production or consumption are greater than the private cost or private benefit by producers and consumers. This leads to market failure.

8. Harcourt Brace & Company Negative Externalities and Market Inefficiency - Graphical Example Assume that the production process emits pollution - negative externality. The cost to society of production is larger than the cost to the producer. The Social Cost includes the private costs plus the costs to those bystanders adversely affected by the pollution. Reflects in a new Supply Curve...

9. Harcourt Brace & Company Negative Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Q Market Market output before accounting for externality.

10. Harcourt Brace & Company Negative Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Q Market Cost of Pollution Social Cost

11. Harcourt Brace & Company Negative Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Cost of Pollution Social Cost The optimum output accounts for the externality. Q Optimum

12. Harcourt Brace & Company Negative Externalities and Market Inefficiency - Graphical Example  The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity.

13. Harcourt Brace & Company Externalities and Market Inefficiency - Positive Externalities Positive externalities sometimes lead markets to produce a smaller quantity than is socially desirable. The Social Costs of production or consumption are less than the private cost or private benefit to producers and consumers. This leads to market failure.

14. Harcourt Brace & Company Positive Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Q Market

15. Harcourt Brace & Company Supply Private Cost Demand Private Value Q Market Market output before accounting for externality. Positive Externalities and Market Inefficiency - Graphical Example

16. Harcourt Brace & Company Supply Private Cost Demand Private Value Positive Externalities and Market Inefficiency - Graphical Example Value of Technology Spillover Q Optimal

17. Harcourt Brace & Company Positive Externalities and Market Inefficiency - Graphical Example The intersection of the demand curve and the social-cost curve determines the optimal output level - more than equilibrium quantity.

18. Harcourt Brace & Company Private Solutions to Externalities  Coase Theorem: –If private parties can bargain to their mutual advantage without cost, then the private market may solve the problem of externalities and allocate resources efficiently. –Private bargaining can internalize the external effects, resulting in efficient solutions (bargaining with a neighbor)

19. Harcourt Brace & Company Failure to Private Solutions Approach  Sometimes the private solution approach will fail because: –The transaction costs (bargaining costs) can be so high that private agreement is not possible. –Failure to achieve a private solution may require that the government intervene.

20. Harcourt Brace & Company Public Policy Toward Externalities  When externalities are significant and when private solutions are not possible, government may attempt to solve the problem by: –Command-and-Control policies –Market-Based policies (taxes or tradeable permits)

21. Harcourt Brace & Company Command-and-Control Policies Usually in the form of regulations: –making certain behavior forbidden –making certain behavior required Examples: –All students must be immunized –Stipulating levels of pollution emissions –Requiring certain pollution control devices

22. Harcourt Brace & Company Market-Based Policies  Taxes: In situations where market failure occurs because of externalities, the government can attempt to internalize the externality by: –imposing a tax on goods with a negative externality. –implementing a subsidy on goods with a positive externality.

23. Harcourt Brace & Company Market-Based Policies  Tradable Pollution Permits: the voluntary transfer of the right to pollute from one firm to another. –Pollution permits which results in a new market for these permits. –Firms that can reduce pollution most easily will be willing to sell their permit, for whatever they can get.